Mutual funds and ETFs: What’s the difference?

Since 2007, May-Investments has pursued an investment strategy that is primarily focused on mutual funds. However, as markets become more volatile, the firm expects to reintroduce exchange-traded funds (ETFs) to the portfolio.

Doug May, owner and managing member of May-Investments, says ETFs were once part of the portfolio but were phased out about four years ago. Today, ETFs represent a way for the firm to gain an investment foothold in certain niche industries.

“As we contemplate future market volatility, I would think that ETFs would find their way back into the portfolio,” May says.

So what’s the difference between a mutual fund and an ETF?

Both are legally pooled funds that own investment assets for their shareholders, May says. Mutual funds are designed so that at the end of the trading day, assets in the fund are valued, and the fund trades at net asset value. Basically, you know at the end of the day what the fund’s price is.

In contrast, ETFs are investment pools whose shares trade over the course of the day, rather than at the close of the trading day. As a result, a significant difference can exist between the ETF’s net asset value and the price at which its stock trades. That difference, whether it is a premium or a discount, can create uncertainty that causes investors to shy away from ETF investments.

ETF are designed to track certain indexes, and when they don’t hit their target, investors can become nervous about ETFs.

ETFs exist in specialized industries – for example, utilities – which makes them attractive vehicles for investors looking to move into certain industries.

“We want to control our portfolio, so we’re more interested in the niche ETFs than in broad-market ETFs,” May says.

Many mutual funds are actively managed by professional managers who buy the best stocks of the class in which the fund specializes. In contrast, ETFs tend to buy the biggest stocks in the class without much regard for quality factors. Such a strategy can result in more volatility than typically happens in a mutual fund, May says.

By combining mutual funds and ETFs in a portfolio, investors can gain the advantage of actively managed mutual funds with the potential gains of ETFs that specialize in niche industries, May says. The combination also means that the relative stability of mutual funds can help temper the potential volatility of ETFs.

When ETFs join the portfolio, what will May-Investments clients notice that’s different? Because of the way ETFs operate, clients could see trading costs and commissions in their portfolios for the first time, May says. However, May says the benefits of combining ETFs and mutual funds in the portfolio can be worth the cost.

“I think clients are looking to us to make the right choice between the two,” May says. “Our clients trust us to make the right decision.”

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